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July 11, 2012

Three Ways to Improve Your Knowledge About Alternatives

Advocates of alternative investing often point to persistent market volatility as a good reason to hold more than just stocks, bonds and cash in a portfolio. These days, being long-only in the three basic asset classes means exposing a portfolio to the damaging effects of increasingly interdependent equity and fixed-income markets, which often rise and fall together in reaction to major market events. By combining traditional and alternative investments, investors may have the potential to profit within a variety of market environments.

Alternative investments—those outside of stocks, bonds and cash—typically have low correlation to traditional investments, meaning that their movements are generally unrelated to the movements of traditional investments. This low correlation may serve to "hedge" or help protect traditional portfolios during sideways or down markets. This is because asset classes that are not correlated generally do not move in tandem with each other—so when the market moves down, for instance, these asset classes may not fall as much as the market in general.

Alternative investments have been available for many years, and have been particularly popular with institutional investors (such as pensions and endowments), which have sought them out in an attempt to manage risk, improve diversification and provide more consistent returns. Today, a wider swath of the investing community is finding it easy to invest in alternatives in ways that provide the liquidity and low cost common among more traditional investments.

The annual AdvisorBenchmarking survey has been tracking advisors’ use of alternatives for several years. The most recent survey found that most (57%) registered investment advisors (RIAs) report they are attracted to alternatives for their ability to diversify a broader portfolio.

As indicated in the chart below, the majority (83%) of advisors use alternatives in their clients’ portfolio allocations, up from 72% in the prior survey. In both those surveys, about 20% of advisors reported having at least half their clients invested in alternatives.

Most RIAs surveyed, as shown in the chart to the left, advocate using alternatives either for many clients (42%) or for a select few clients (32%). Those results are consistent overall with the prior year.

This positive view of alternatives is echoed by a recent study from the consulting firm McKinsey & Co. It showed that assets under management for global alternatives reached record levels of $6.5 trillion at year-end 2011, having grown at a five-year rate more than seven times that of traditional asset classes. And that growth was despite a falloff in alternative assets under management during the worst of the financial crisis, 2008-2010.

When investing, it is important to have realistic expectations. While it is tempting to think alternatives will guarantee enhanced results, this is not necessarily the case. As with any investment, there is the potential for up and down days, months or even years. Additionally, there is no guarantee that diversifying a portfolio with alternatives will mitigate the risk of experiencing investment loss or result in a profit.

Here are three suggestions to improve basic knowledge and be ready to discuss alternative investments with clients.

1) Understand What Alts Are

“AI” or “Alts,” as alternative investments are often called, expand investor choices for targeting, managing and mitigating risk—which is particularly helpful at a time when many clients are more risk-conscious. Although the roots of alternatives go back to the first hedge funds, today they are widely varied in purpose and structure. Usually classified as either an asset or a strategy:

Alternative assets, also called "hard assets" or "real assets," are tangible items that hold inherent value—that is, their value is not derived from other sources. Among these are commodities, currencies or real estate.

Alternative strategies are tactics or tools used to create value through investments in traditional and nontraditional asset classes. Some of these are long/short strategies, momentum strategies, managed futures or absolute return (or hedge) strategies.

Many alternative investment providers have education materials available to help advisors understand and better implement such investments in client portfolios. The key benefit of alternative strategies is to expand investor choices for targeting, managing and mitigating risk, at a time when investors have become more risk-conscious.

2) Consider New Structures for Implementing Alts

Alternative asset classes and strategies have been used to mitigate various risk exposures in thoughtfully constructed portfolios. Until recent years, advisors needed to rely on private placement vehicles to access the investments, which carried disadvantages in terms of liquidity, transparency and regulatory oversight. The structural problem meant that clients most sensitive to risk were unable to access the potential risk-mitigation benefits of an alternative investment strategy. New, more accessible structures are expanding the choices for implementing the universe of alternative strategies, including traditional mutual funds and exchange-traded products. An investor’s ability to help mitigate stock market risk—without relying exclusively on bonds and cash—may be critical to investment success in the years ahead.

3) Tell Your Clients What Alts Can Accomplish

The story of alts is long and colorful, but for clients is straightforward: alternatives help expand and diversify the sources of return in a portfolio, thereby expanding the range of market conditions in which a portfolio may be able to generate positive results; and adding alternatives to a broadly diversified portfolio reduces portfolio risk (as measured by volatility), improving the potential for investors to meet their objectives. That’s a great story for investors and one that can help keep them focused in times of market turmoil.

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AdvisorBenchmarking is a research and analysis center focused on the registered investment advisor (RIA) marketplace. Study results quoted in this article are based on the 300-plus RIA firms that took the online survey in March-May 2011. The service is aimed at helping advisors grow and enhance their firms by comparing how their businesses fare against other advisors. Advisors also learn best practices of the most successful advisors in the business.

AdvisorBenchmarking is an affiliate of Guggenheim Investments. The analysis on AdvisorBenchmarking.com is based on the number of completed surveys and reflects only information from those surveys. This information is intended to be general in nature, and these overviews are no substitute for professional, legal or consulting advice. This information should not be construed as advice from Guggenheim Investments or any of its affiliates.

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